2014 outlook - All posts tagged 2014 outlook

Add Morgan Stanley Wealth Management to the long list of bond-market skeptics entering 2014. Morgan Stanley’s base case sees the 10-year Treasury yield moving to 3.25% and familiar 2013 themes carrying over into this year, namely shorter-maturity bonds outperforming longer-maturity ones at least for the first half of 2014. More from MS:

We also believe corporate bonds will continue to outperform rate-sensitive products as investors look for income opportunities. For now, investors will be using last year’s playbook, given the ongoing dual headwinds of rising rates and relatively rich valuations.

MS sees “limited upside” in corporate bonds after spreads in investment grade and high yield credit markets tightened by 27 and 119 basis points, respectively, in 2013. MS points out that high-grade bonds currently trade with a spread of 113 basis points over similar duration Treasuries, while high yield trades around 400 basis points over, both the lowest spreads seen since 2007 (my Current Yield column in this weeks’ Barron’s magazine explores the subject of shrinking junk-bond spreads). MS again:

We believe this year the broad investment grade and high yield markets will generate returns of roughly 0% to 1% and 3% to 4%, respectively, based on coupon income and modest spread tightening offset by rising yields and falling prices.

As for munis, MS sees interest-rate volatility continuing into 2014:

[P]rudent positioning on the yield curve and coupon structure helped mitigate some of the pain from rising rates. The increased market volatility unlocked value. Credit spreads for both A-rated and BBB-rated bonds remain distended. That said, we think it is still worthwhile to play defense for those concerned about price volatility and selective offense for those with the patience to target value and see it through. For now, investors should lock in short- to intermediate-muni bonds in the four- to nine-year maturities….

The best news for muni investors is that we see continued improvement in credit quality, state revenues and housing prices… When prudently executed, the case for tax-exempt municipal bonds remains strong.

While we expect munis to outperform Treasuries, a lot of challenges remain, and the municipal market could be choppy in the next year. A lot will depend on fund flows and the supply/redemptions dynamic. The latter should be supportive, but a strong rally is not likely without a stabilization of fund flows. We think that it will be difficult for fund flows to stabilize until the Fed starts to taper. The muni market could react adversely in the early stages, but we think that outflows will reverse – similar to the 2005 experience – as valuations likely become attractive and the benefit of tax exemptions increases with rising rates.

Similar to 2013, Barclays sees headline risk in 2014 that could come from Puerto Rico and Illinois, as well as from underfunded pension and benefit plans across the muni market. Otherwise Barclays says “overall municipal credit quality is actually improving due to modestly increasing revenues” while “the largest issue regarding municipal credit quality will be the increasing payments required to meet retiree obligations: pensions and health care.”

Among tax-exempt bonds, Barclays sees value in long bonds, given the underperformance of longer-duration municipal bonds and a steep muni curve. From Barclays:

We expect the muni curve to flatten next year, in line with expectations in the Treasuries market. We also think that the A-rated portion of the index looks attractive at current levels given its underperformance this year, as well as improving municipal credit quality. On a sector basis, we believe the following sectors offer relative value: hospital, IDR/PCR, transportation, and water and sewer. Finally, muni HY looks attractive versus US HY, with the ratio of the former to the latter at 119%, an all-time high.

On the taxable side, Barclays says it sees value in intermediate taxable munis and the power sector within long taxables.

It’s been a lousy year for muni bonds, which are down 2.7% on average in 2013, and Morgan Stanley thinks we’re in for more of the same in 2014, predicting another loss for the muni-bond market next year.

In a report today, Morgan Stanley muni strategist Michael Zezassees a base case (with a 60% probability) in which the muni market posts total returns between -1.7% and -4.1% next year. He says that scenario factors in a rise in Treasury yields “that is initially rapid as better growth causes Fed tapering,” with the 10-year Treasury yield hitting 3.45% and the bulk of negative returns coming in the early part of 2014,

Morgan Stanley’s bull case scenario for munis sees returns between 3.5% and 6.0%, which assumes the U.S. economy remains hampered by slow growth and low inflation, and the 10-year Treasury yield falls to 2.3%. Tts bear case scenario sees muni losses between -6.2% and -7.8%, which assumes a sharp rise in both U.S. growth and bond yields, notably with the 10-year Treasury yield rising above 4%.

Zezas calls munis “a credit market with a rates problem, disposed to negative returns and volatile liquidity as the economy improves and rates rise.” While all fixed income markets are sensitive to changes in interest rates, “munis have developed an outsized vulnerability,” Zezas writes.

What should an investor do? Get out of the way of losses if rates rise, and look for an opportune time to jump in again. From Morgan Stanley:

In sum, the muni market should initially struggle to cope with higher rates, but the risk neutralizes at some point in 2014. The signals for a constructive point of entry are 1) loss cushions outpace expect rate increases and 2) market duration has extended. Such constructiveness is supported… by ongoing broad credit fundamental improvement, which suggests that excess risk premium in the market is attributable to challenges of liquidity rather than credit.